Options Costs

Options Costs - Cheap vs. Expensive?

Strategies for Profit!

by Ian Harvey

Introduction

One of the first things option players must realize in order to be successful is that they are not simply trading stock prices; they are also trading volatility. Option costs consist not only of intrinsic value but also time value, which factors in the implied volatility of the stock. Any move in the stock must overcome this time value for the option to yield a sufficient profit.

Established large-cap companies typically have very low implied volatilities. Their options costs are therefore often priced cheaper than options on other stocks, which in turn mean a smaller stock move is required to turn a decent profit in the options. While stocks that have high implied volatilities need to make a bigger move for a similar profit, the chance of that big move is considered to be much higher.

This is the trade-off every option buyer must consider. On one hand are low-priced options that can profit handsomely on a relatively small move in the underlying. On the other are high-priced options on stocks that need to make a sizable move for the option to profit, but the potential for that sizable move is greater. In the analysis below, strategies are examined to determine which ones would have been more profitable so far in 2012.

Low Implieds vs. High Implieds

One way to measure the extent by which options are mispriced is to look at an equities straddle returns. A long straddle is a volatility play that combines a long call and a long put with the same expiration date and strike price. This strategy makes money when the stock moves enough in either direction to overcome both premiums.

Specifically for this analysis, assume that for each regular monthly expiration cycle, you purchased an at-the-money straddle 10 trading days before expiration (the third Friday of the month). Now assume you held the straddle until expiration and closed it at intrinsic value. This is done for each stock with options that met some pretty strict liquidity criteria -- then group the stocks into four different "brackets" according to their implied volatility. In bracket 1 are stocks with the lowest implied volatilities; bracket 4 has the highest.

Notice the average implied volatility
of each of the brackets below. The only bracket that showed a positive
return using straddles was bracket 2, which averaged a 6.5% return per
trade. Bracket 1 showed a modest 0.8% decline, which was the second
best. The first two brackets also had the highest percentage of positive
straddle returns. Therefore, we could conclude that for the first part
of 2012, options on lower-volatility stocks proved to be better deals
than their high-volatility counterparts.

May Expiration

The data below is similar but only considers the most recent May expiration cycle. This assumes you purchased straddles at the close on May 4 and held the trade for the two weeks leading up to May expiration on the 18th. This two-week period was an interesting time in the market because the the Standard & Poor's 500 Index (SPX) collapsed 5.4% in that timeframe, making put options huge winners.

The first three brackets have especially good returns, averaging around 60% on the straddle trades. The highest-volatility stocks in the fourth bracket stand out as their straddles significantly underperformed the other brackets. Bracket 4 had an average return of only 25% per trade ("only" because of the comparison to the 60% average in the other brackets). Also, 60% of the straddles were positive in the fourth bracket with 18% of them doubling in value.
These figures are also underwhelming compared to the other three brackets, which saw an average of 71% positive returns with 27% of them doubling. So, in the most recent expiration when observing options costs, the highest-priced options were once again the worst deal – options costs become extremely important to the bottom line!